Is Your 401(k) Failing You?

I recently collaborated on an article that asked, “What financial advice did you receive from your parents that no longer applies?” As a soon-to-be new parent, I’ve been thinking through the life lessons I want to teach my child and the values I hope to instill. Since I work in the finance industry, it shouldn’t come as a surprise that conversations and lessons around money and being responsible with finances are part of that list.

One piece of advice that I have struggled with personally over the years is the recommendation to max out your 401(k). Is that advice all it’s cracked up to be? While I think there is merit to setting a savings goal on a bi-weekly basis and automating that decision to invest in your future, is a 401(k) the best investment vehicle to use?

I’ll answer this question the way most client conversations start … it depends.

Not Your Timeline

A trend I’ve been seeing in the financial planning space is a departure from the conventional framework of retirement. Our firm recently conducted a study that shows people no longer view retirement as a hard stop at age 65, but instead view it as “the next chapter.” In conversations with my clients, I’ve found that the age they want to embark on this next chapter is getting younger and younger, with some folks hoping to start it as early as age 50.

Do you see a problem with that? I certainly do. In most cases, distributions from a 401(k) or IRA are penalized for early withdrawal if accessed before age 59 ½*. Folks who want to start their next chapter sooner than age 59 ½ likely will have to deal with early withdrawal penalties on top of income taxes if their 401(k) is the only account they’ve used to invest in their future.

Tax-Deferred. So What?

Speaking of taxes, this is another characteristic of the traditional 401(k) that often rubs me the wrong way. Account holders get so caught up on the tax-deferral upfront that they forget about the taxes that ultimately come due on the back end. In retirement, if you have a 401(k) with an account value of $1 million, it does not have the same purchasing power as a taxable account or Roth IRA of $1 million. After factoring in the income taxes that come with distribution, that same account will only carry the purchasing power of $750,000 if you assume a tax rate of 25% in your distribution years.

By putting all your eggs in the 401(k) basket, you may also be missing out on some strategic tax planning opportunities like contributing to a Roth 401(k) or Roth IRA while your marginal tax bracket is low relative to your lifetime earnings and future tax rates.

False Sense of Security

My least favorite aspect of a 401(k) is that it can often create a false sense of security around retirement. I’ve worked with clients in the past who have come to me ready to retire because, in their minds, they’ve done everything “right.” They’ve been working for 30-plus years, maxing out their 401(k) for the majority of their working career, and feel they have enough money to retire. And when the numbers and retirement projections don’t work out in their favor, it’s not an easy conversation to have. In some cases, the numbers don’t work because they have unrealistic expectations for retirement. Often, though, it comes down to the diminished purchasing power that comes from a tax-deferred account.

The formula for preparing for a successful retirement is so much more than just maxing out your 401(k) every year. It starts with creating a financial plan, defining financial goals, inventorying a client’s assets today, and projecting savings ability and investment expectations. Only after these steps have been completed can you identify the “right” formula for a successful retirement. And spoiler alert … it’s not going to be the same formula for everyone.

What Now?

I hope you haven’t taken this the wrong way. This is not a piece to bash your 401(k) and your current investment habits. Your employer 401(k) is a crucial part of your financial picture, but it’s not going to be your golden ticket to retirement. Be sure to talk to your financial advisor about using other investment vehicles to round out your financial picture.

*If your 401(k) allows for early withdrawals, you may be able to tap into the 401(k) account as early as age 55 – if you keep your money in the account. As soon as you rollover the 401(k) to an IRA, this exception would no longer apply.